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Book Title

The Pension Challenge: Risk Transfers and Retirement Income Security

Chapter 4: Company Stock and Pension Plan Diversification
Krishna Ramaswamy

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Defined contribution (DC) plans are an important and growing form of private retirement systems. In many of these plans, the employee’s contribution to the plan is matched by the employer, so there is a strong incentive to participate. The employee takes charge of his own investment decisions, thereby bearing the risk of fluctuating returns to the chosen investments. The authors develop the “efficiency” measure of the diversification level in a DC plan participant’s portfolio. This measure computes how much additional risk reduction can be had by reallocating investments among the choices permitted within the DC plan, without changing the expected return of the currently chosen portfolio. The authors also show that the plan participant can privately avail himself of insurance against the decline in his wealth attributable to his undiversified position within the DC plan. The measure proposed uses standard mean--variance analysis, thereby avoiding the difficult problem of forecasting the mean returns to investments within the DC plan menu.